Why we pay high interest rates when we borrow but earn little when we deposit

Published on Saturday, 10 November 2012 19:40

Written by Jun Vallecera / Reporter

NOTHING confounds the average man on the street more than the wide expanse of ocean between the deposit rate given when one entrusts one’s savings to the banks, and the interest charges one is levied for taking out a bank loan.

Latest data from the Bangko Sentral ng Pilipinas show a fractional interest earning of just a tenth of a percent for a savings deposit in most banks across the country.

It is true one could still get interest earnings exceeding 5 percent for a savings deposit nowadays but one has to be a fairly large entrepreneur and financially well-off and able to set aside P1.5 million or more and not touch it within three to five years to deserve a return this size.

Borrowing from the banks, on the other hand, literally costs an arm and a leg, with bank lending rates on all maturities averaging 6.124 percent as of latest.

The rates barely changed from the last auction of government IOUs in the form of Treasury bills and Treasury bonds that, to some degree, influence the rate at which hapless borrowers are charged for loans taken out of the various lenders.

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For most people it is only fair that banks are seen as greedy but lazy financial critters eager to extract the littlest monetary value from anything and everything one holds dear in life, including that pink ceramic piggy bank one has given the youngest daughter one Christmas ago.

But is this perception fair or even half accurate? The BusinessMirror went to the experts to find out.

According to Tony Moncupa, president and chief executive officer at East West Bank, the issue boils down to numbers and good old communication having bogged down somewhere.

According to Moncupa, bank services like loans are governed by a number of factors that ultimately determine how much those loans cost to clients who need them.

He said there are so-called friction costs that keep loan rates within particular ranges that may not be appealing to a given set of potential borrowers.

“I think there is an under-appreciation on the cost incurred by the banks, how the market operates and the state of the banking profits,” he said in an e-mail, explaining why it was that banks extend to the depositor just a tiny piece of interest earnings for a tidy sum of savings when the industry extracts a princely sum in interest charges for even the littlest of loans.

He said interest margins, which reflect the difference between the cost the banks incur for obtaining the funds and the interest earnings the banks derive extending the loan, had been pinched for a long time it is a tribute to the innovations the banks have adopted to remain profitable in recent years.

“If you look at net interest margins of the industry in the last few years, you will see that it has been going down. In fact, banks [still] feel the margin squeeze,” Moncupa said.

Bank executives elsewhere have claimed it was extremely rare for banks to have posted interest margins of 5 percent or 6 percent, as actual interest margins the past many years “are much lower.”

Things would have proved more challenging than they already are if not for the fact that bank-loan volumes have risen during the period to compensate for the falling loan margins, Moncupa said.

Bank loans have, in fact, been growing at double-digit rates all year, averaging 13.5 percent as of end-September, based on data obtained from the Bangko Sentral ng Pilipinas (BSP).

That they continue to grow is an indication of continued demand for financing from the productive sectors of the economy, although data also show some signs that loan growth is slowing.

BSP officials, led by Governor Amando M. Tetangco Jr., have, of course, dismissed the notion that loan growth is not robust as the numbers suggest, saying the bulk of those loans continues to be driven by borrowers from the production (as opposed to the consumption) side.

Nevertheless, quite a few observers have noted that while loan growth remains on the positive side, the pace of growth has, in fact, slowed from as high as 19.2 percent in the first half of the year to where it is, at only 13.5 percent as of latest.

Bank executives have said liquidity has never been an issue when it comes to lending activities, as there is a surfeit of liquidity in the system best shown by the volumes of special-deposit account (SDAs) that are approaching P2 trillion even as we speak.

SDAs are captured bank funds that ostensibly could not be optimally deployed to generate revenues for their owners but are merely deposited in the vaults of the BSP, where they earn premium interest over the 3.5-percent borrowing rate of the central bank.

Banks that prefer SDAs over traditional lending are in a sense lazy, avoiding the risk of counterparty default by engaging only the central bank where the funds are safe.

That the SDAs have grown tremendously from just a few hundred billion pesos prior to the global financial crisis in 1997 to almost P2 trillion at present is an event that attracted the attention of critics, who point out that the banks would rather engage the BSP, where they have a low-risk, high-return relationship, than go out and engage in real lending activities, where its counterparty may not pay up at all when the loan matures.

Moncupa said the overhead and losses that the banks incur from those who default on their obligations are quite high.

That loan-default rates could be punitive for some of the lenders is shown by non-performing loans of just over 2 percent of the banks’ loan portfolio, or some P70 billion so-called bad loans, out of the total P3 trillion that was extended to all stripes of borrowers as of end-August this year.

He also said competition among banks has benefited the ordinary borrower in that individual lenders cannot afford to charge more than the rival charges for loans at the risk of losing market share.

“Given the fragmented nature of the local banking industry, competition is ensuring that lending rates reflect the cost of funds, the risk taken, the intermediation costs and the overhead costs to deliver banking services,” Moncupa said.

He pointed out the banks are no longer compensated for 18 percent of the funds the industry sets aside as deposit reserve as mandated by regulations.

Moncupa said demonizing the banks as greedy and stingy critters is also unfair if one understands that the bulk of the industry’s earnings as a whole does not come from funds deposited by the banking public but come from their trading activities instead.

“A significant part of the robust income of the banks comes not from lending but from trading. And even with that, the industry is only earning on average, around 13-percent to 15-percent return on capital. And this relatively good level of profitability has gone on only in the last few years. Before this, the industry saw a long period of low profitability,” he said.

However, if one asks Rajan A. Uttamchandani what he believes to be the solution to the conundrum, the president and chief executive at Esquire Financing said the regulators conceivably could mandate the banks lend to particular sectors like they already do to such sectors as the small- and medium-scale entrepreneurs, or SMEs, for example.

Uttamchandani perfectly knows what he talks about, having actually focused Esquire’s lending activities on SME borrowers for close to two years already.

He acknowledged most banks would rather engage its treasury people, the guys who buy and sell interest rate, foreign currency and debt notes and other securities for a living, than toil with the few banks at present that make money the good old-fashioned way by actually lending money to those who need it.

“The opportunity cost for a bank is the amount it can earn from trading gains using its treasury. If banks and government financial institutions are to be persuaded to lend, stiffer penalties must be imposed by the BSP to force banks to take more educated risks in lending,” he said.

Uttamchandani is president and chief executive at Esquire Financing, which specializes in lending to that oft-forgotten sector called SMEs.

Esquire Financing walks the talk and actually lends money to SMEs, its loan book having grown from negligible at the start of the year to P1.5 billion as of end-September.

The banks, on the other hand, have to be persuaded to lend to the sector from whose ranks originate nearly all of the country’s budding businessmen in the form of mandatory lending equal to 2 percent of total loan portfolio for small-scale businesses and another 8 percent for medium-scale entrepreneurs.

The Esquire executive said most banks fail to observe the mandated lending levels and often engage financing company executives like himself to help the big boys hit the mandated lending levels.

“There needs to be more focus on the SME market. SMEs need to focus on leveraging their business so they aren’t left behind during the move toward Asean [globalization] of our markets,” he said.

This pertains to that point in the near future when the country’s financial and allied services will go regional, and banks and insurance companies, for instance, have to compete not just with local rivals but with some of the meanest and most competitive business empires in Southeast Asia.

The integration of the local financial industry with the rest of the region is set to take off by 2015.

It is important for banks and financial institutions to have a strong capital base and to deliver the various services in an efficient and cost-effective manner.

Among regulators, the measure by which retail interest rates actually benefit the enterprising man on the street via appropriate adjustments in policy levers is best indicated by the interest pass-through rate.

This pertains to the degree and speed by which the policy adjustments in the rate at which the BSP borrows from or lends to banks translate also to equal adjustments in interest charges for loans and other forms of credit accommodation.

Simply put, if the bank lowers its policy rates by 25 basis points like the BSP has done yet again late in October this year, then there should be a similar reduction in bank-loan charges equal to 25 basis.

Ideally, the interest pass-through matches the adjustment done on the policy rates of the central bank, and this is readily seen at the retail level when a borrower approaches the bank and its loan charges have moved appropriately in the same manner.

The increase or decrease in the official interest rate is actually passed on to other interest rates, such as the rate for loans maturing in three, nine months, one year and well beyond.

Central banks often reduce their policy rates to boost growth and do the opposite to dampen inflation, or the rate of change in prices of services and goods.

Prior to the October policy-rate reduction, the BSP had a 25-basis-point rate cut in January, another 25-basis-point cut in March and again in July, when another 25 basis points were shaved off the policy rates.

Interest pass-through could be sluggish or quick, depending on whether the transmission of monetary policy was efficient or effective.

A quick, uniform and complete interest pass-through is said to lead to a well-functioning, competitive and efficient financial system.

A sluggish pass-through could mean problematic areas in certain aspects in the economy.

But according to Deputy BSP Governor Diwa C. Guinigundo, the interest pass-through, given that the policy rates have been slashed a full percentage point since the start of the year, stands at 80 percent at present.

This shows not all of the interest-rate adjustments made by the central bank at the policy level were reflected in the retail interest charges charged on bank borrowers like you and me for reasons that Tony Moncupa of East West Bank cited earlier.

BSP Governor Tetangco, prior to embarking on a long official mission abroad, pointed out a total four policy-rate adjustments have thus far been made this year that reduced the policy rates a total 100 basis points.

Late in October this year the BSP announced another 25-basis-point reduction at the rate at which it borrows from or lends to banks, more to encourage the banks to lend the trillions of pesos worth of funds at their disposal that have not been optimized for lending.

Tetangco and many central bank governors in the region view the ongoing sluggishness of business activities in Europe and the United States with apprehension and likely to have a negative knock-on impact on the country’s exports, which is a key growth driver.

Tetangco and the rest of the seven-man Monetary Board see that liquidity has never been a problem but that lending has not been optimized just the same.

He called on both the public sector to spend more than its allotted budget for the year to stimulate consumption and boost demand.

As for the private sector, Tetangco called for greater investment activities than had been undertaken thus far so that the rich pickings of liquidity may be put to greater and more productive uses.

This was why it was important for the banks’ lending rates to fall further than they actually have so that the demand for loans also lifts as a consequence.

Tetangco has made it known there remains room for still more policy adjustments down the line should such a stimulus prove necessary to ensure continued growth not just this year but over the next 18 to 24 months.

Domestic prices, the state of the global economy and a host of other factors need to be considered when such an adjustment becomes imperative, he said.

The literature on interest pass-through showed certain economies in the wake of the global financial crisis in 1997 were slow to transmit the benefits of the scale back in policy rates on to the retail level, the Philippines included.

Factors such as the maturity mismatches of the banks’ loans and deposit portfolio had an effect on how the industry adjusts lending rates.

Pass-through rates also varied from country to country, especially with respect to retail rates, the literature said.